Bruce Berkowitz may have made his name with his $11 billion mutual fund, but it's his partnership that's making headlines these days.

While the average hedge fund was mired in the single-digits in 2013—the HFRX Global Hedge Fund Index stood at 6.72% for the year—Berkowitz's $200+ million Fairholme Partnership Fund was up 33% net of fees. Berkowitz launched the long-only hedge fund (which has a Caymans-based counterpart, the Fairholme Offshore Partners Fund) with $23 million of internal capital in January 2013 and opened it to outside capital in October.

Fred Fraenkel, president and chief research officer of Miami-based Fairholme Capital Management, said the idea of launching a hedge fund began to form three years ago:

“[W]e at Fairholme ran into the reality that Bruce's investment horizon [didn't] match up that well with the daily liquidity available in a mutual fund in 2011,” Fraenkel told FINalternatives in a recent phone interview. “[T]hat was...the kind of year that a real deep-value... investor longs for, where he sees stressed companies, he's identified them, he wants to own their stocks.

“The world...believes that things are really bad and you, in performing your analysis on the companies, figure out that things are not bad, they're actually getting much better. Because what happens is, the prices go down a lot and you load up, and that's exactly what we wanted to do in 2011 but because of a bunch of circumstances—including that [Berkowitz] was named the Manager of the Decade for [domestic] equities in Morningstar for 2000-2010—he had huge inflows in front of that year, and then as soon as things started looking bad in the newspapers and on TV, we had dramatic outflows. So Bruce was confronted with not only not being able to buy more as the perceived crisis made stocks go down, he had to sell stocks off to meet the liquidity needs.”

The takeaway, said Fraenkel, was “that there was a divergence in the business plan and the investment plan.” What Fairholme needed, they decided, was investors who understood how good Berkowitz's long-term record was and were willing to wait with him “until they realize huge returns.”

Out of that realization came the Partnership. The fund has an unusual fee structure which Fraenkel said was designed to reward those investors willing to “wait with” Berkowitz.

“[W]e don't charge any management fee so we don't make anyone pay unless they make money and we receive a declining percentage of the profits that we take depending on how long they want to entrust their money with us,” said Fraenkel.

Strategy

The hedge fund is designed to deliver “the same exact investment, process, strategy and hopefully results that Bruce has achieved for 25 years,” said Fraenkel, “which is deep-value investing where we do an enormous amount of work on a small number of names and buy them when they're exceedingly stressed and sell them when everybody wants them.”

The difference between this strategy as a mutual fund and this strategy as a hedge fund, he said, is that “there's huge constraints in the mutual fund business with regard to how concentrated you can be, how much in certain industries...The Partnership allows Bruce to be unconstrained in his selection and concentration decisions in the portfolio manager process. So he did, in the past, buy things that got restructured, but a lot of that ends up for a period of time being relatively illiquid and that's not ideal in a mutual fund where someone can come and cash out tomorrow. So you can do that much more easily in the Partnership where you know the money's tied up.”

Fraenkel said “nearly all” of the investors in the fund have signed on for five years.

“The people that have invested and that we expect to invest more, and the people that we're talking to are family partnerships, endowments, foundations—people who truly have very long-term timeframes, that aren't necessarily focused on a consultant telling them what quarter to get in and what quarter to get out,” he said.

Success Stories

Asked to describe a successful Fairholme-style investment, Fraenkel named two: AIG and Bank of America.

“We were the first and at one time the only institution in America that bought AIG when it was coming out of the original government restructuring,” said Fraenkel. “When everyone thought that it was over we went through all the details of why that wasn't going to happen—Bruce actually ended up discussing that with the US Treasury—and we were in it the whole time until everyone started to realize that this was a great insurance company and that the parts of it that really got it into trouble had been cast off...and that it was going to be a completely different company going forward...[W]e were there early, we continued to be there, we bought more and more and we're by far the largest shareholder of AIG and it's had a tremendous ascension but we don't think it's anywhere near its intrinsic value and that's what we hold to, we wait until the market is willing to pay the price that better reflects the value of the company. We're still in it.”

As for Bank of America, Fraenkel said they bought in when the bank had entered “what market participants were calling a death spiral.”

“[W]hen it got to $5, Bruce held a conference call for 6,000 investors where he interviewed the CEO for an hour and a half, he asked Brian Moynihan every tough question he could possibly come up with and, literally, that was within days of the bottom of the stock, people started understanding what was and wasn't really happening with Bank of America. And we still own Bank of America too.”

Banner Year

Fraenkel said the Partnership Fund hedges by holding onto enough cash to “buy more of something if it goes down,” adding that Berkowitz generated his 33% net return with an average cash position “probably of over 20% for the whole year.”

But at the end of the day, a long-only fund is bound to do well in a bull year that saw the stock market return 30%.

So what happens in a bear year?

“It's almost impossible for us to have a really great year when stocks have a really bad year,” said Fraenkel. “Bruce's famous quote is, 'I don't know why one revolution of the earth around the sun is the right measurement for portfolio performance.' We don't look at things on a one-year basis for our investment process...”

The key, he said, is to look at Berkowitz's five-year track records over the 25 years for which he has audited performance.

“That's a little more than 250, five-year rolling periods,” said Fraenkel, “and during that entire time there is only one five-year period when he was down. During that same period the market was down 49 times.

“So the concept is, if you give Bruce your money for five years, you're going to turn out all right.”

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